Why ‘progressive’ taxes cause inequality
January 7, 2013, 7:40 am
Filed under: Uncategorized

Now that we’ve raised marginal tax rates slightly on the $450k+ crowd, all the Smart People are assuming that that crowd will have a little less money. But what if the tax increase is mostly offset by salary inflation among them?

Say you work for a multinational corporation and they send you to live in England for a couple years. Inevitably they’ll be compensating you for your rent and living expenses and moving costs, and making it worth your while on top of that. How do they give you this compensation? In dollars? Or pounds? A lot of it unavoidably comes in pounds because that’s what you’re having to buy stuff in.

What if the value of pounds goes down/price inflation there goes up, having the effect that the exchange-rate between GBP and USD (i.e. GBPUSD) goes way up – $1 going farther / 1 GBP going less far? Does the corporation keep giving you the same fixed-number of GBP and say: ‘Sorry, you just gotta deal with lowered purchasing power of what we’re giving you. Yes, the rent on your flat is now double what it used to be, but no we’re not doubling your housing-expense or per-diem compensation, you should just move to a gang-infested crack house and live on Pakistani street meat.’ Etc. Does that work for you? Of course not. One way or another the company will more or less arrange to pay you in constant-USD-equivalent terms (assuming USD is relatively stable through this, of course). They will for example compensate your rent in GBP, and so, if your GBP-rent doubles, they’ll end up shelling out more GBP.

Well, because of the progressive tax code, a salary is kinda like getting paid in a foreign currency too. Or rather, a sequence of foreign currencies. People like to think of their salary as one single number of ‘dollars’ – “I make 37,500 dollars a year” – but in actuality that’s not quite correct. You don’t make ‘dollars’. You earn a salary in a currency called Pretax Dollars.

And Pretax Dollars are different currencies than dollars. Moreover, they are multiple currencies. To make the numbers easier, suppose you’re single, the deductible is $10k, and the next tax bracket is $25-50k. Pretax Dollars(0-10k) is one currency. Pretax Dollars(10-25k) is another. And Pretax Dollars (25-50k) is a third. How much ‘money’ are you being paid per year? You’re not making “$37,500″. You are actually being paid in three different currencies:

  • 10k of Pretax Dollars(0-10k), plus
  • 15k of Pretax Dollars(10-25k), plus
  • 12.5k of Pretax Dollars(25-50k).

The ‘exchange rates’ between all those ‘currencies’ and actual dollars floats. It moves around. It moves around because of the tax code.

What happens when the government ‘raises marginal tax rates’ on one of the brackets is simply that the government has adjusted the exchange rate between that bracket and actual dollars: Pretax Dollars(450k+) are now worth less, in USD, than they used to be.

So guess what? To give those employees the same purchasing power, corporations will just end up adjusting salaries upward to compensate. Since Pretax Dollars(450k+) are suddenly worth less, folks who get paid (partially) in them will demand, and get, more of ’em.

Result: higher (nominal) salaries for the rich!

No such effect is occurring on Pretax Dollars(<450k), of course, so all of those people can expect to be paid the same nominal salary more or less.

I wouldn’t expect the adjustment I’m describing to occur instantaneously of course, but I do expect it.

If I’m right, then the ‘inequality’ people like to complain about – one guy’s (nominal/Pretax) salary being N times that of another guy – is at least partially caused by a progressive tax code. And to fight such inequality, you should want a flatter tax code.

3 Comments so far
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Kevin Williamson over at NRO was thinking along the same lines. Slightly different, but similar in effect:

Comment by ColoComment

Yup, some similar points. Great minds…

It’s important to keep in mind that both he and I are just touching the surface of these issues. The main point to get across is that how progressive/unequal the compensation *ends up being* is a far more complex and subtle calculation than just looking at the marginal-tax-rate table.

Comment by The Crimson Reach

Mark Perry on income inequality.

Comment by colocomment

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